NorthStar Realty Europe Corp (NRE:NYQ)

NRE is a NYSE listed REIT with a focus on European commercial real estate; its portfolio predominantly consists of prime office properties in Germany, UK and France; and it is the only NYSE listed REIT with a European focus. I believe that at current share price of $8.70, NRE trades at a significant discount to my estimated NAV of $15 per share.

Key stats

The key stats above assume a 15% drop in cash flow per share and a 5%-10% fall in value of NRE's property portfolio owing to currency risk further to recent events in the UK (see discussion on currency risk & NAV calc below). It is worth bearing in mind that only ~22% of NRE's in place rents come from the UK. 
   
Investment case

My investment case for NRE is as follows:

1.       NRE’s portfolio comprises mainly of prime office properties in key cities of Germany, UK and France (represents 76% of the total portfolio); the overall portfolio has a weighted average lease term of 6.2 years and is 88% occupied; tenant quality is solid with the top tenants being blue chip and creditworthy. See below for more details on the portfolio.

2.       At current price the stock offers a solid 6% dividend yield compared to 1.38% paid by the 10-year U.S. Treasury note and the 2.1% yield for the Standard & Poor’s 500. NRE’s dividend yield compares well with comparable European REITs where continental office focused REITs offer a 4.8% dividend yield and UK REITs offer a 2.85% dividend yield.

3.       My conservative NAV per share forecast for NRE is $13 - $15 per share, implying a 50% - 70% upside to current share price.

4.       The current economic outlook in Europe should prolong the low interest rate environment and a continued period of quantitative easing by both ECB and BOE is likely. This should continue to support cap rates.

5.       I acknowledge that the outlook for rental growth, particularly in the UK, may be negative following Brexit; my valuation assumes no rental growth. It is worth bearing in mind that only ~22% of NRE’s in-place rents come from UK; and that too consists of prime office properties leased to quality tenants. Bar a disastrous economic situation, the portfolio & current rents should hold. In summary, NRE’s 6% dividend yield along with current significant discount to intrinsic value offers a buying opportunity. The market appears to have overreacted to the current uncertainties in the UK, and seems to have failed to acknowledge the quality and geographic mix of NRE’s real estate portfolio.

Currency Risk

Given the recent big drop in GBP against USD, currency is a risk area. ~22% of in place rents come from the UK which will be negatively impacted given the fall in GBP against USD. Assuming the GBP depreciation results in a 30% drop in income from the UK, and allowing for a 10% drop in income from Europe due to EUR risk, cash flow per share would fall from $0.90 per share to ~$0.77 per share, giving a cash flow yield of ~9%. If NRE maintains its dividend payout of 70%, this would give a dividend per share of $0.54 with a dividend yield of 6%. This should still support my NAV per share estimate of $13 - $15 per share. 

Valuation

NAV

Below is my NAV per share estimate for a range of valuation of NRE’s portfolio – starting with the most recent valuation undertaken by Cushman & Wakefield and ending with the implied portfolio value based on current share price. 

The current share price of $8.70 implies a ~20% discount to the most recent valuation undertaken by C&W. I believe this to be overdone and think that a more realistic NAV in the range of $13 - $15 per share is a better reflection of intrinsic value. My estimate is supported by both comparables.

Comparables

In the below table I have shown the Price / NAV and dividend yield for comparable European REITs – both continental office focused REITs and UK office focused REITS.

As can be seen, UK REITs currently trade at a significant discount to NAV following the UK’s vote to leave the EU. Continental European REITs continue to trade at close to NAV. NRE’s portfolio is split 75:25 between continental Europe and UK; applying this split to the comparable P/NAV, I get an implied NAV per share for NRE of $15 per share.

Further, using NRE’s portfolio split, the comparable universe offers a dividend yield of 4.3% compared to NRE’s dividend yield of 6%. Applying the comparable universe’ dividend yield to NRE would support a price per share of $14.

Cash flow

I forecast cash flow per share for NRE of $0.90, implying a cash flow yield of 10% based on current share price. My range for intrinsic value per share of $13 - $15 implies a cash flow yield of between 6% - 7% and a Price / Cash flow of between 14x - 17x (both reasonable).

Implied Cap rate

My forecast FY16 NOI for NRE of $129.4m implies a cap rate of 6.35% based on Enterprise Value of $2bln. My intrinsic value per share of $13 - $15 would give a cap rate in the range of 5.4% to 5.7%. Given NRE’s portfolio mix and quality and the anticipated prolonged low rate environment in Europe, I believe these cap rates are supportable.

 NRE’s real estate portfolio quality and mix

The below tables and graphs are taken from NRE’s financial statements and presentations to market and provide a snapshot of NRE’s portfolio mix and quality.

Portfolio overview

Portfolio overview by geography

Rent concentration by geography

Major tenants

Source for portfolio information shown above - NRE's financials and management presentation

Other considerations

·         NRE is a newly created REIT, having listed in NYSE in November 2015 when it was spun off from NorthStar Realty Finance Corp. It have limited analyst coverage and it is the only US listed REIT with a focus on European real estate. I believe that due to these reasons, it has traded at a discount to its peers in Europe; the recent fall in European markets has broadened this discount. I think this is overdone and at some point down the line, may be as analyst coverage improves, this disconnect between NRE and its peers should narrow.

·         NRE pays a fixed management fee of $14m per annum to NorthStar Asset Management which, per my calculation, equates to a PV of $233m or $3.84 per share (applying a 6% discount in perpetuity to the $14m). The NAV needs to be perpetually discounted for this management fee.

·         In addition to the $14m fixed management fee, NRE is obliged to pay additional management fee of 1.5% of any new equity issuance. NRE currently has $187m of stock settable notes which are due to mature at the end of FY2016; it can either pay down the notes at maturity, or convert them to equity. If the notes convert to equity then NRE’s management fee will increase by $2.8m per annum (1.5% * $187m), implying an additional discount to NAV of $47m (or $.77 a share). Such a scenario should still support a NAV per share of $13 - $14. However, I see the risk of the stock settable notes being converted to equity being low on the basis that NRE started off with $340m of stock settable notes and has bought back $150m of the notes from open market purchases so far. Given NRE’s cash flow generation, I believe that the company continue to buy back the notes or repay it at maturity. Further, management are incentivised to increase cash flow per share more than they are incentivised to increase the management fee (management fee reduces cash flow per share and the higher incentive fee payable to NSAM).

·         The company has repurchased 4.3m shares from November 2015 for a total of ~$50m. If the current discount to NAV persists, I expect the company to continue to repurchase shares.